Behavioral Finance
Behavioural finance and bias
Predictable departures from rational choice, what they cost, and the decision process that limits them.
Definition
Behavioural finance documents the systematic ways people deviate from the model of the rational, self-interested decision-maker. The biases are not random: they recur in defined situations, which means they can be anticipated and designed around.
The costs show up as forgone return, delayed action, poor diversification, and mispriced risk. Because the effects are systematic rather than noisy, a decision process can reduce them even when willpower cannot.
Intuition
You cannot out-think a bias in the moment. You can change the process so the bias has fewer decisions to ruin.
When to use it
- Designing an investment or capital-allocation process.
- Running a post-mortem on a decision that felt obvious in hindsight.
- Coaching a team through a high-stakes, uncertain choice.
When not to use it
- As an excuse to dismiss every disagreement as bias.
- As a label for a decision that is merely different from your own.
Formula
Expected value of a bet
EV = Σ pi × outcomei
The rational benchmark a fair gamble is measured against.
Formula
Loss aversion
Pain(loss) ≈ 2 × Pleasure(equal gain)
A stylised ratio from prospect theory: losses weigh roughly twice as heavily as gains.
Worked example
Pricing the delay
৳1,000,000 is either spent now or invested at 9% a year for 20 years.
- 1
Compound
৳1,000,000 × 1.09²⁰ = ৳5,604,411.
- 2
Compare
The present-biased choice forgoes about ৳4,600,000 of future value.
- 3
Reframe
The decision is not spending ৳1,000,000 today; it is giving up ৳5,600,000 of future money.
Present bias is expensive precisely because the cost never appears on a statement. Compounding makes delay a measurable financial decision.
Common mistakes
- Believing awareness alone removes a bias; without a process it returns under pressure.
- Judging a decision by its outcome instead of by the process and the information available at the time.
- Letting a sunk cost set the agenda for the next decision.
How it connects
affects
Changing the source moves the target.
- Risk and return: Bias changes how much risk a decision-maker actually accepts.
relates to
Useful to study together, in either order.
- Financial modelling: A model exists to make assumptions explicit and testable.